Going With The Flow?

Going With The Flow?...You probably saw that the 2Q GDP report came
in relatively strong, as was absolutely no surprise at all. Inventories were
rebuilt relative to the contraction in 1Q, which is academically additive to
the GDP calculation. Government spending was also quite strong, especially
defense spending. No surprise at all. Non-residential real estate construction
also added to the strength in the headline number. But what stood out quite
strongly is that personal consumption expenditures slowed dramatically, up
a whopping 1.3% on an annualized basis. For those who have read our work over
the years, you know that one of our primary macro themes is that the US economy
is not running on a traditional business cycle, but rather on a credit cycle.
These days that thought can in a sense be extended to the global economy in
that the growth rate in monetary aggregates among the major industrialized
countries across the planet has been running double digits.

If indeed we are anywhere near correct in this thematic view of life, data
in the 1Q Fed Flow of Funds statement demands attention and monitoring as we
move forward. Getting right to the point, the issue that stood out to us like
a sore thumb in reviewing this material was what sure as heck appears to be
change at the margin in terms of the character of household leverage. Who knows,
maybe we're making a big deal out of nothing, but what we are seeing are the
very first signs of change in the direction of household leverage acceleration
that until now has been consistent and intact for many years, if not decades
in a good number of cases.

A while back now, we penned a discussion questioning just what the baby boom
generation was going to do for money/liquidity as they entered retirement years.
Our observation at the time in reviewing household balance sheets was that
households held plenty of real estate and qualified plan assets (profit sharing,
IRA, 401(k)), but very little in the way of cash. We questioned for how much
longer would households, and especially the baby boomers, be able to continue
leveraging up as retirement years for the boomers were fast approaching. And
lastly, we pointed to the fact that throughout a good portion of their adult
lives, the boomers had learned to embrace asset inflation for their "savings" activity,
evidenced by appreciation in stocks and real estate, and the lack of traditional
savings as would be calculated by the savings rate.

So let's start with a very brief review of household asset inflation circumstances
as perhaps being the genesis responsible for this change at the margin that
we are seeing in recent quarterly numbers. As always, the charts tell a big
story, so we'll try our best to keep the commentary short. First, the big overview
of asset inflation. What we've done in the chart below is to calculate the
percentage of real estate and equity price appreciation responsible for household
net worth growth by decade over the last half century plus. As you can see,
increasingly gains in real estate and stock prices have accounted for ever
greater amounts of total household net worth growth since the 1970's. And importantly
we need to remember that the baby boomers as a group really began to come of
age in the late 1970's/early 1980's. In essence, what they've known in their
adult life and have thoroughly enjoyed is household asset class inflation.
Of course as a group they drove this very phenomenon in purchasing ever more
residential real estate and common stocks (in IRA's, etc.). You get the picture.

But within the current decade itself, and especially over the last few years,
this is starting to diminish directly due to residential real estate softening.
Of course, directly from Hank Paulson's mouth in the Fortune article we cited
to you earlier this year, he hopes "stock price appreciation has more than
made up for the decline in residential real estate values". (We continue to
suggest you not forget his exact words as we move forward.) Nonetheless, in
1Q of this year, increases in household real estate values and equity holdings
accounted for the smallest amount of total household net worth expansion in
eight years at least.

So the big question now becomes, how is this impacting household financial
management choices? Let's get right to what we believe are the early anecdotes
of what may ultimately become very important change. Change that if it becomes
a trend will most definitely influence domestic economic outcomes ahead. Very
simplistically, let's start with the character of household debt. The following
chart could not be more basic in character. It's the year over year change
in household debt outstanding. What we've done is mark the periods in red of
official US recessionary occurrences.

The conceptual message seems pretty darn clear. When the rate of change in
household debt growth decelerates meaningfully, the US has experienced recession.
You don't need us to tell you that this makes all the sense in the world. We're
a consumption based domestic economy that has been heavily debt financed. When
the rate of change in debt slows, so does the economy. Simple enough? And what
we see in the current period is a very sharp slowdown in household debt growth
as of now. In our minds, this demands monitoring as we move forward.

Certainly the key area where household leverage growth has slowed is in mortgage
debt assumption. For now, the following chart is showing us a relationship
we've historically seen turn down maybe once a decade. It's household mortgage
debt as a percentage of GDP. Now of course the ever growing financing of residential
real estate is a phenomenon we've seen play out over sixty years at least.
But you can see the long-term growth channel we've drawn in that has clearly
been meaningfully breached to the upside this decade. As of now, we're still
far above that long-term channel and just beginning to correct downwards. Is
this the beginning of a meaningful change in trend? For now it's too early
to call, but this is indeed change after almost a straight up decade of acceleration.
Looking ahead, we'd suggest it's far from a stretch of the imagination to believe
this trend could revisit the long term up channel. Personally, it's what we
expect. And if so, total household leverage growth is set to decelerate meaningfully
ahead. A key secular question at this point has to be, as the boomers push
ever closer toward and into retirement years, just how much more debt will
they be willing (or able) to shoulder?

Okay, here's where we believe the charts and trends start to get interesting
and force us to wake up and take notice of potentially very meaningful change
at the margin just beginning to develop. The following are all simply updates
of charts we've used in the past, but the current period change will be self-evident.
The first in this series is the very simple relationship between household
cash and household liabilities. You may remember that our definition of household
cash is as broad as can be. We include all household "banking products", per
se, but also include all household holdings of bonds, inclusive of Treasuries,
Agencies, corporates, muni's and mortgage backed paper. Implicitly, we are
assuming bond holdings could be converted to cash at a moments notice. So what
follows is simply total household cash less total household liabilities over
the last six decades.

For now the change is minor in the current period in that this measure has
stopped expanding ever further into negative territory, but what we believe
is important is that this is the first trend break we've seen after sixteen
years of literally consistent deterioration in this relationship. Again, for
now the trend change is minor, but we need to watch in the periods ahead for
corroboration of potential long-term trend change. And why is this important?
A change in trend as we are now seeing suggests one of two things, or both
- households are borrowing less and/or saving more. And if indeed that's the
case, we have to believe there is less household liquidity then available for
consumption moving forward.

A corollary to what you see above are these same numbers presented in a ratio
format. Again, keeping it very simple, below we are looking at household cash
(liquidity) as a percentage of liabilities. As you can see, this ratio has
been in consistent and continual decline since 1989...until the current period.
Prior periods of upward reconciliation in this ratio has been seen in or around
official US recessions - 1970, 1974, early 1980's.

Like the chart of nominal dollar cash less liabilities, the uptick in the
chart above as we are seeing tells us households are either saving more and/or
paying down debt.

Next in the hit parade is this same household liability number now set against
disposable personal income. In one sense, it's a measure of how much debt households
have been able to support relative to their income at any point in time. And
quite understandably, as interest rates in general have fallen since the early
1980's, households have been able to support ever larger total debt relative
to their ongoing and growing income streams.

As you can see, we've marked in the chart with red dots each occurrence whereby
this ratio contracted over the last sixty years. As we've noted, every single
time in the last six decades where this ratio has declined, we've seen an official
US recession. Again, this speaks volumes about a debt financed consumer based
economy. Of course in the current period we are once again faced with a contracting
ratio. For now, it's a one period occurrence. Too early to sound the alarm
bells. But history is telling us to sit up and take notice.

Even we'll be the first to admit that the next chart here is a bit graphically
dramatic, but again very simple in terms of design. What this chart documents
for each period is the relationship between growth in household liabilities
and growth in disposable personal income. Without sounding outlandish, this
ratio has simply collapsed over the last few quarters after reaching what were
unprecedented heights. As with prior charts, we've marked with red dots the
periods where we've experienced official US recessions. Each one of these recessionary
periods is characterized as having happened with a decline in this ratio. Of
course absolutely nothing over the last half century even comes close to what
has occurred over the last five+ years in terms of the magnitude of expansion
and contraction.

As we promised, trying to keep it short, there you have it. Although we believe
each individual chart tells its own story, our main point in this discussion
is that collectively, these relationships represent multi-year or multi-decade
trend breaks for now. They are now occurring in simultaneous fashion. Just
a coincidence? We think not. Moreover, we suggest an important need for continual
monitoring as these trends quite similarly hug trends in powerful demographic
changes. Could it really be that as the boomers push near and into retirement,
what has been their dramatic impact on asset inflation through continual expansion
in household leverage is changing? We believe this is indeed the primary question
and message to continue to monitor in these relationships. As we've suggested
many a time, the credit cycle is the key. And this is a slice of the broader
credit cycle as it applies to households. Households key to longer-term consumption
trends important to both the US domestic and many a foreign exporting economy.
You know we'll be checking back in on a quarterly basis to monitor whether
these initial trend changes remain intact, or are simply blips on the ever-growing
leverage expansion screen.

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